Real Problems for Real Estate Investors Knocking at the Door

October 23, 2008

There's havoc being wreaked in the real estate market due to dramatic volatility created by the failure of major financial institutions and selective governmental bailouts.

That's the present situation, according to the Real Estate Capital Institute, a Chicago-based organization that monitors realty capital market information. October data from the institute reveals that new construction of commercial property financing is almost at a halt, lending remains extremely restrictive, and the only buyers and borrowers who are active in closing deals right now are those rich with liquidity.

The worst areas for real estate right now are in southern California, Las Vegas, Phoenix and southern Florida, says Allan Domb, director of the Greater Philadelphia Association of Realtors. "These are disaster areas where between 70 [percent] and 90 percent of sales taking place are short sales."

Short sales are those in which the loan amount is greater than the selling price, and the bank is taking a loss on the loan. The reason these parts of the country are being so badly hit is because of the high degree of speculation that has taken place there in the past.

"People in those areas were taking negative amortization mortgages, and now they're finding that their debt is greater than the value of their real estate," he explains.

That's not happening in the Greater Philadelphia area to the same extent, Domb adds. "We may see only up to 5 percent of our sales being short sales. In the peripheral areas of the city, we've seen real estate sales taper off and in many cases dry up, but, in primary locations like Society Hill, Washington Square and Rittenhouse Square, properties are continuing to maintain value."

Sales velocity is slower across the board, but in these particular areas it's not as slow as in the city's periphery.

Who to Bank On?

Across the nation, consumers are scared of the stock market, says Domb: "They're worried about which banks will be open tomorrow, but they feel relatively safe investing in real estate in a prime location, such as Rittenhouse Square. I think prime real estate locations in most cities are still holding value -- it's the peripheral locations that are not."

If media reports have not scared real estate investors witless to date, rest assured that the situation is going to get worse, says Robert Edelstein, co-chair of the Fisher Center for Real Estate and Urban Economics at the University of California at Berkeley.

"We're going through the worst combination of events: credit tightening with a downturn of the economy," he explains.

"The credit tightening causes demand for real estate of all sorts to decline, and makes it hard to borrow money from the banks. But it's going to get worse, because there's a world recession going on, with no obvious engines of growth for economic upturn. This is a very nasty situation."

The problem is that, to date, credit has been much too easy to obtain, Edelstein reflects. "The underwriting standards have been very lax, and loans were made that should not have been made," he says.

"What's happening now is a correction, but it has the potential to be very, very severe, due to a combination of factors that may make this downturn longer and worse than we've seen in perhaps the last 50 years."

If you are still in the market to purchase real estate, multifamily properties remain the most desirable and attractively priced funding opportunities in the capital markets, according to the Real Estate Capital Institute. Borrowers are bridging the equity gap by providing personal guarantees as additional collateral, but except for select agency programs such as FHA/HUD, most funding sources are waiting for more clear market signals for the remainder of the year.

The only good news, says the real estate institute, is that as far as commercial real estate debt is concerned, overall default rates and profit performance remain at historically favorable levels.